The trend in the great investing debate of active versus passive management is clear, but that doesn’t mean the issue is simple or even close to settled.

While index-based funds have been the clear winner over the past several years, both in terms of performance and investor preference, analysts say the current economic environment is one where simply tracking the market may not provide the best return or protection against risk. And in equities—where gains are expected to continue in coming years, just in a less broad-based fashion—having the right manager can protect against volatility by readjusting to changing conditions.

“We believe the active/passive debate does not yield a clear-cut winner. In our view, both strategies can be utilized together to help maximize expense reduction without fully eliminating the investment opportunities offered by active managers,” analysts at the Wells Fargo Investment Institute wrote in a recent report.

“We believe the active/passive debate does not yield a clear-cut winner. In our view, both strategies can be utilized together to help maximize expense reduction without fully eliminating the investment opportunities offered by active managers.”
Wells Fargo Investment Institute

Passive funds simply track a benchmark like the S&P 500
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while active funds have their portfolio components chosen by an individual or team. In recent years, the move has leaned decisively toward passive. According to Morningstar, active funds saw outflows of $285.2 billion last year; passive funds attracted inflows of $428.7 billion. (Despite that, more assets continue to be held in active strategies than passive—$9.3 trillion versus $5.3 trillion, as of year-end 2016.)

Investors have taken to them for a variety of reasons. Index funds are not only cheaper than actively managed ones—passive U.S. stock ETFs have an average expense ratio of 0.344%, according to Morningstar, though the most popular have fees below 0.1%; the average for active funds is 0.864%—but they offer better performance. According to S&P Dow Jones Indices, the number of active funds that have outperformed over the long term is essentially zero.

Those stats are skewed, however, by the fact that Wall Street has been in a particularly good environment for passive management. Bull markets, the current of which celebrated its eighth anniversary earlier this month, favor passive strategies through “rising tide” environments. Because the market’s gains have been widespread for years, with basically all sectors participating, it has been exceedingly difficult for active managers to surpass that performance, especially over long periods, and especially factoring their higher fees.

“Active managers may outperform their passive peers in the latter part of a recovery, where we believe this recovery may be,” Wells Fargo wrote.

Data bears out the idea that broader active outperformance is cyclical, as seen in the following graph, which was provided by Altus Securities and uses data from the Center for Research in Security Prices.

That chart, however, gets at one of the hurdles faced by active management. The long-term average has roughly 40% of active managers outperforming, in aggregate. That means investors still have better odds sticking with the benchmark, especially since they can’t invest in “active” as a category—they need to select a specific fund.

Picking an active manager

With thousands to choose from, and with each offering its own strategy or investment philosophy, finding the rare actively managed fund that would outperform net of fees for the long term is a daunting task, and one that investors are generally opting against.

Still, if the market is in fact entering an environment where the right manager can preserve capital or boost returns, it is a task investors should consider.

The first step in this, analysts said, was to view active management as a complement to one’s portfolio, not a replacement to the index funds that are widely seen as the best core holdings for any investor. In a market that favors value, for example, a manager who has a growth orientation can provide the same diversifying benefits as bond exposure.

Second, analyze the funds as potential long-term holdings, not temporary positions to ride out periods of volatility or weakness. And finally, look for subcategories of the market where the professional analysis of a manager can add value, analysts said.

“Your probabilities of success with an active manager are better in high-yield bonds than government bonds, in emerging markets rather than developed, and in small-cap equities rather than large cap,” said Steve Lipper, senior investment strategist at Royce & Associates LP, an active management firm that focuses on small companies. “Because there are more small companies and less analyst coverage of them, managers can more easily find values there than they would be able to in the large-cap space.”

Within those categories, Lipper said, there are a variety of metrics that can help gauge the quality of a fund and its manager. In addition to the fund’s fees and past performance—evaluated against their benchmark over a variety of market conditions and economic cycles—prospective investors should look to see how long the manager has overseen the fund, whether they invest their own money in it, and what degree of “active share” it has.

Active share is a measure of overlap between a fund and the benchmark it tracks (for example, a large-cap fund and the S&P 500). The higher the active share, the less correlation it would have with the benchmark, giving it more value as a diversification tool and creating the potential for outperformance (though this also increases the odds of underperformance).

Lipper recommended funds with an active share of at least 80%, the same figure quoted by analysts at Morgan Stanley Investment Management.

“If you want an active manager, then you want an *active* manager,” Lipper emphasized. “You want him because he doesn’t look like the benchmark.”

He pointed to the Royce Pennsylvania Mutual Fund
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one of his firm’s flagship offerings. The fund, which has $2.4 billion in assets, has active share of 88%, according to its website, and the fund’s manager—Chuck Royce, who wasn’t available for a comment—has operated it since 1972. In a market rarity, Royce’s tenure actually exceeds the life of the Russell 2000
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the benchmark his fund now tracks, which was introduced in the late 1970s.

A table comparing the annualized performance of the Royce Pennsylvania Mutual Fund against the Russell 2000. Note how the fund’s outperformance becomes more prominent over a longer time horizon.

Royce Funds also requires that its lead portfolio managers have at least $1 million of their own money in the funds they oversee. Data have shown this to be a good indicator of future performance, with such funds outperforming ones where the managers don’t invest their own money.

According to a September 2016 Morningstar report, a group of funds where the managers don’t co-invest had “a meager 35% success rate” over a five-year period. “Those with between $100,001 and $500,000 [invested] had a 43% success rate, and those with more than $1 million had a 47% success rate,” wrote Russel Kinnel, the firm’s director of manager research. “Because about one third of funds were merged away or liquidated over that five-year stretch, a 47% success rate is actually quite good.”

Even with these parameters, however, passive funds are nearly universally seen as the best choices to make up the bulk of an investor’s portfolio, even from the point of view of active managers themselves.

“If you want passive exposure, vanilla funds are the way to go. But if you want something that isn’t correlated to the market, or which relies on an alternative data set, active managers are out there looking for bigger returns,” said Petra Bakosova, chief operating officer at Hull Tactical Asset Allocation, and a portfolio manager to the Hull Tactical U.S. ETF
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